Emergency fund: how much you need and how to build one

An emergency fund is money you set aside for costs you can't predict: a breakdown, a medical bill, a month without income. It isn't for a trip or an opportunity. It has one job: to stop an unexpected cost from forcing you to take out a loan, lean on a credit card or sell an investment at a bad moment.

What sets it apart from ordinary saving is its purpose. Saving goes towards something you want. An emergency fund is for what you hope won't happen, and ideally you never touch it.

How much you need

A common guideline is three to six months of essential expenses. Notice that it's expenses, not income, and only the essential ones: housing, utilities, food, insurance, transport and minimum debt payments.

To work out your number:

1. Add up what you would pay in a month if you cut everything that isn't essential.
2. Multiply by three for the minimum and by six for the full target.

Here is an example with made-up numbers: with essential expenses of 1,800 a month, your fund would be between 5,400 and 10,800.

Three months or six

Aim closer to three months if you have a stable job, a second income in the household and few people depending on you. Aim for six or more if you work for yourself, your income is irregular, your industry is unstable or one income supports the household.

If those numbers feel far away, don't be discouraged. Even a few hundred covers many repairs and stops the first surprise from landing on a credit card.

Where to keep it

There are three conditions: it should be safe, available at short notice and separate from your everyday money. A savings account apart from your main one is usually the simplest option. If it pays some interest, so much the better, but returns aren't the point.

Don't invest it in the stock market. An emergency can coincide with a bad spell for markets, and you would have to sell at the worst time. Don't leave it in your everyday account either: if you can see it, it will get spent.

How to build it, step by step

1. Set a small first target. For example, one month of essential expenses. It's more achievable than six months and already gives real protection.

2. Decide on a monthly amount. Divide the target by the number of months you want it to take. At 300 a month, you would reach 5,400 in 18 months.

3. Automate it. Schedule a transfer for the day after you get paid. If you have to decide every month, some months it won't happen.

4. Use extra income. Bonuses, tax refunds or one-off money speed things up considerably.

5. Balance it with debt. If you have expensive debt, build a small cushion first, then focus on repaying. Afterwards, go back and finish the fund.

If you aren't sure where the money will come from, review your fixed and variable expenses. To fit it in with your other goals, read how much to save each month.

When to use it

Before you touch it, ask three questions: Is it unexpected? Is it necessary? Is it urgent? If all three answers are yes, that's what it's for. A broken heater qualifies. A sale doesn't. Nor does annual insurance, because you knew it was coming: for those costs, set money aside separately.

Using it isn't a failure. It's exactly what is supposed to happen. Afterwards, all that matters is filling it back up.

How to tell if you're on track

What you want to know isn't how much is in it, but how many months it covers. That number goes up when you save and down when your expenses rise.

In a spreadsheet, just divide the fund's balance by your essential monthly expenses. Abacova has a dashboard card, Months of cover, that works out how long the money in your everyday, savings and cash accounts would last at your average monthly spending. Abacova has no dedicated emergency fund feature, and that card counts all of those accounts, not only the fund, against your average spending, not only the essentials. Even so, it's a good guide, and creating a separate account for the fund lets you see its balance at a glance. Transfers between your own accounts don't count as expenses.

Where to start

Work out your essential expenses for one month today, and open or choose a separate account. Schedule a transfer, even a small one. What matters is starting: a modest fund is better than none.